5 money moves a yield-hunting trader is making now

Bond expert’s tips for safety, income from unforgiving market

SAN FRANCISCO (MarketWatch) — The coffers of the biggest and best U.S. companies are flush with cash, which is great for them because they don’t have to pile on more debt — but terrible for investors seeking solid corporate bonds with attractive yields.

To pocket meaningful yield in this climate, income-focused buyers have been tempted to move down the credit ladder to lower-rated bonds.

Abdullah Karatash.

Yet as bond trader Abdullah Karatash points out, corporate bond investors nowadays have little tolerance for high risk. In this storm, steerage-class borrowers need money the most — yet are the most unlikely to get it. Money instead is hunkered on the top deck.

A growing climate of mistrust among global bankers, clouds over some of the biggest European banks, and tumbling stock prices across developed and emerging markets have set credit markets on edge.

“The insane, head-spinning volatility in equities has carried over into the bond space,” said Karatash, the New York-based head of U.S. fixed income credit trading at France’s Natixis, in a recent telephone interview.

All of which makes for a hair-trigger bond market, where investors gravitate to securities that are easy to sell on rumor or news — even if the trade-off is a paltry yield.

“There’s a huge premium on liquidity,” said Karatash, who worked at Barclays Capital and Lehman Bros. before joining Natixis. “You want to be as liquid as possible so you can deploy to areas where there is the most value. But bearing in mind the overall weak [corporate] balance-sheet environment, you also need to be able to get out.”

Indeed, bond buyers are taking the path of least resistance, akin to their stock market brethren. “Quality” in bond-land goes hand-in-hand with defensive sectors such as pharmaceuticals and utilities, while even the most highly rated debt from banks and other financial firms is radioactive.

“The funding environment is challenging for everybody across the board,” Karatash said. “People are going to look back years from now and say 2011 was the year of a massive flight to quality.”

Quality will continue to be a prominent theme given Karatash’s view that 2012 and 2013 will see a greater number of business failures and distressed asset sales, as companies needing to issue new bonds after several years find the cash spigot is down to a trickle.

“The guys who need the money most are getting push back from investors and dealers and underwriters,” Karatash said. “If you’re a corporate it makes a lot of sense to come to the market now and issue. The problem is you don’t have the dealer support that you had a year ago, except if you’re the highest quality issuer, in which case you don’t need that dealer support.”

With credit so tight, he added, “We could begin to see more and more companies come under pressure and we’re likely to see corporate bankruptcies pick up.”

What’s a corporate bond buyer to do? High-quality, investment-grade credit has been outperforming lower-grade offerings. Karatash said he expects this trend to continue. This is no time for heroes.

“It’s a little early to be contrarian,” he said. “If the corporate bond market is any leading indicator as it was up to 2008” and the financial crisis, Karatash added, “I would definitely urge caution.”

Here are some ways that Karatash approaches buying and selling in today’s bond market.

But many U.S. firms sport a double-A rating, and investors have shown a high comfort level with those securities. Right now, in fact, the sweet spot for corporate bond investors is double-A rated paper, Karatash said.

“That’s where you’re getting the safest bang for your buck,” he said.

“High-grade, high-quality is looking good,” Karatash added. “Double-A rated is doing surprisingly well in this market. Even when everything else is widening out and there’s a panic-like stampede away from risk, you’re seeing that holders of these bonds are comfortable, and you’re seeing more demand.”

2. Utility bonds add power

Utilities have a reputation for being safe, predictable and boring income providers. Yet just in case, Karatash favors a higher cut of utility debt known as a first-mortgage bond. These taxable securities represent a first claim on the property and earnings of the issuer, or as Karatash puts it, “direct recourse to the cash.”

Investors, understandably, have a healthy demand for first-mortgage utility bonds. Recent issuers of these bonds, Karatash noted, include Exelon Corp.
EXC, +0.36%
and PPL Corp.
PPL, -0.09%
Another issuer, Progress Energy Inc.
PGN, -1.42%
is triple-B-rated, but while the quality of this debt is lower, the first-mortgage provision offers relative safety, Karatash said.

3. Prescription for ‘Big Pharma’

As with utilities, pharmaceutical company bonds are part of the defensive strategy that’s called for now.

“Your goal is to hold something safe that gives you more back than what you’re paying to hold it,” Karatash said. “If a company has a firm business model, if the cash flow is steady, if the company isn’t going to carry any significant event risk — that’s what you’re looking at.”

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